The Fed vs Inflation Part 2 of 3
"The Balance Sheet & the Possible Largest Risk to the Financial Markets"
Prior to diving into, what we believe is the largest risk to markets, Let’s set the stage first…
In the past few weeks we have seen a steeper deterioration in markets as CPI data came in slightly higher than expected. On September 13th, 2022 the S&P 500 had its largest 1 day drop since 2020, ending the day lower by -4.32%. The data discovered that food and rent costs seem to be the culprit to the elevated prices. Once this occurred, rates such as the 2 Year T-Notes spiked to 3.75% from 3.58% just 24 hours prior (that’s a large move and remember on January 1st, the 2 Year Notes were returning 0.78%, yikes whoever is bullish on bonds prices). In addition to this, the yield curve inverted even further. This is not ideal for banks since this is how they make their money.
What and why do we care about the “Yield Curve”? Inversion of the Yield Curve…? Now you lost me…
Let’s break it out since it will be worth noting for future reference. A bank serves 2 primary functions in our world:
Savings or to hold our hard-earned money somewhere safe.
Pro: Keeps our cash liquid or ready to deploy at any time for living expenses, discretion spending or investing.
Con: Earns the lowest possible amount of interest while not being used. (Usually marked near short term rates) *But that is the price you pay to keep the funds in accessible at any time or in liquid form.
Secondly, to Borrow funds in the form of a loan.
Pro: Allows us to use the funds for any type of purpose and essentially “leverages” our own money (aka equity) above what we have, to be able to purchase items we would not able to afford
An simple example, a house.
Con: Pay Interest on the borrowed funds from the bank (Usually the rate could be marked slightly above a Treasury Note (bond) that has a similar time duration until maturity.
Essentially if you take out a car loan for 5 years, you may be paying slightly above a 5 Year Treasury Note (depending upon your credit score of course!)
So, how a bank makes money is by receiving more interest from loans, than what they are paying to savers in the form of interest.
Profit & Interest Rate Spread = Interest Received (from a loan to customers) – Interest Paid to Savers
Ultimately, if the Bank starts paying savers more interest than what they are receiving from their customers loans…then banks have a problem. Important note, that the banking system is not quite 1 for 1, or for every $1 in savings, they have $1 in loans, yet it can still pose serious problems if the yield curve continues to further invert.
Inversion of the yield curve = Interest Received – Interest Paid to Savers
[Example of inversion or Negative Net Interest Rate Margin: -1% = 5% Interest Received – 6% Interest Paid to Savers]
Again, the yield curve is not something we should just disregard as this plays a factor into what we believe is the largest risk to the markets.
So, what do we believe is the largest risk to the markets? Liquidity Risk
…or removal of cash out of the financial markets. This is set to begin in September as the Fed will begin the “Tightening” process.
What is liquidity risk?
It is a certain type of risk that creates excessive volatility due to the lack of capital (money) coming into the financial markets. Simply ask yourself, how does a market stay elevated? Simply put, it is the perception of what buyers are willing to pay for an asset, but what if buyers start running out of capital to invest in? How can you support prices with out capital? And lastly, why are we thinking that this could be a risk at all? It all pinpoints to the amount of cash the Fed has injected into banks starting as early as 2008.
Let’s fast forward and review the past Fed’s Policy since 2020…
The Fed purchased Treasury Bills, Notes, Bonds & MBS’s (see definitions below) from commercial banks.
Pro: Adds cash to commercial banks; elevates the cash reserves
Analogy: think of filling up your car’s gas tank with fuel; the more fuel the farther you can drive. The more cash, the more banks can lend.
Con: Can lead to inflation if there is too much credit or loans outstanding in the economy while supply of goods and services are limited due to the lack of labor.
Secondly, the Fed artificially pushed the Treasury prices higher which in turn lowered the yields or rates inversely. (Further explanation: Coupon payments or interest payments stay the same as the prices of the bonds increase, diluting the return. Similar to dividend yields moving lower as the price of stock moves higher)
Pro:Equity prices traded all time high levels. Why? Capital rotated from stocks to bonds since investors need a return on their investment. The bond market is not providing a sufficient yield so why be invested in the bond market.
Con: Artificially pushed speculative asset classes to new highs along with creating overvalued companies within the entire equity markets.
2021 Results of these actions were many but the most eye-opening was:
M2 Money Supply increased +$6.3Trillion while the Fed added $4.7T in excess cash reserves in the exact same time frame.
(Another term? Yes, another term to know; M2 stands for liquid cash that resting in current checking, savings, and other very liquid instruments such as money market funds which could be held by banks or brokerages. This does not include cash in retirement accounts.)
(WALCL: Federal Reserve Balance Sheet) (GDP: Gross Domestic Product) (M2SL: M2 Money Supply)
Now, no one is arguing that more cash is a bad thing, but it is under our belief that with the lack of labor and excess cash at everyone’s disposal is what lead to a multi-decade record of 9% inflation rate per annum. Now that inflation has risen substantially and no longer carries the assumption of being “transitory” or temporary, the Fed needs to pump the brakes on the inflow of money through asset purchases, which raises the level of systemic liquidity risk.
Let me give a visual on how liquidity works in the system. Very much as oil provides a lubricant to a car’s engine, the inflow of liquidity acts as an agent to keep markets functioning properly. If you drain oil from a car’s engine you run the risk of an engine block seizure. If you drain liquidity from the markets, buyers and sellers become more erratic due to not having as much cash on hand to purchase securities. To put it simply, if your credit card limit gets cut in half, you do not have as much capital to use for purchases, therefore limits the amount of capital flowing into the economy, therefore reduces the ability to keep markets elevated.
How can you really assume this you say? Well let’s look at the correlation of GDP versus the stimulus the Fed created post pandemic, or early 2020.
Last example, remember the Flash Crash of May 2010? I am not proposing that we are going to have a flash crash, but this is a representation of liquidity being removed from the financial system.
During this event, a young trader began “spoofing” the market, or removing bid orders within the S&P 500 Mini Futures markets, which triggered several stop orders executions creating a cascading sell off in the amount of near 10% within of 45 minutes. Keep in mind that market functionality and the economy are still 2 different worlds, both correlated to each other but separate real-world entities.
Ultimately, cash and liquidity flows are the sustaining lifeblood to all tradeable markets.
In conclusion, you may be asking yourself, well how will markets look moving forward? Of course, we an